this article is from issue 45 of the journal Soundings written in May 2010.
The stories that we tell about the economy are part of the political battle. In April 2010 the leaders of the Euroland countries agreed an `emergency bailout’ of Greece, lending the fiscally stricken country billions of euros to prevent it defaulting on its debts and reaping untold havoc on the European banking system. The future of the euro itself was questioned. Now Greece is expected to `take its medicine’ by dealing with its deficit through a combination of spending cuts and the liberalisation of its economy. But the medicine suggested by financial markets, other European governments and much of the media may well prove poisonous, and to involve enormous economic and social costs.
There are many questions that must be asked. How did this situation arise? Who is to blame? What should happen now? And on whom should the costs fall? The emerging consensus appears to be to blame a profligate Greek state for overspending in the good years, and to suggest that the only answer is spending cuts and austerity, paid for by the Greek people.
But perhaps a more important question to ask would be how this narrative came to hold sway – and whether or not this widely believed narrative itself has an impact on the developing situation. And here the recent work of George Akerlof and Robert Shiller has much to offer: their recent book Animal Spirits (Princeton 2009) points to the importance of behavioural economics, and the ways in which perception influences reality. Recognising the central importance of stories in macroeconomics is crucial to understanding the drivers of the Greek crisis, and to understanding the route ahead.
A death spiral averted?
There is no denying that Greece is in a terrible mess. The revelation late last year that the budget deficit was closer to 13 per cent of GDP than the 4 per cent the government had been claiming sparked downgrades to its credit rating, a sell-off in government bonds, and mounting pressure from financial markets to begin a programme of savage public spending cuts. In such a situation, as the price of sovereign bonds falls, the interest rate charged rises and the costs of servicing the debt increases. In a nightmare scenario a country can then find itself in a financial and fiscal death spiral, as falling bond prices drive up interest charges so that merely servicing an existing debt takes up an ever greater share of already stretched government revenues.
The short-term nature of much of the Greek government’s borrowing left it especially vulnerable to a sudden loss of confidence in its ability to meet its obligations. Debt had to be refinanced at higher interest rates (above 7 per cent in April), and the very real prospect of default reared its head. An immediate collapse was averted by the emergency loan of 30bn from Euro member states at a 5 per cent interest rate, coupled with a further 15bn from the IMF. However the stability lasted only weeks, before a second, larger bailout was required.
For the Greek people the tragedy is only beginning. The `bailout’ package agreed will allow Greece to refinance the debts that are due in 2010, but putting its finances on a sustainable path will require a `fiscal adjustment’ (i.e. spending cuts or tax rises) equivalent to 10 per cent of GDP. In effect Greece has not been `rescued’, merely given a stay of execution before the axe falls – of at most two years.
The power of stories and the meaning of Keynes
Investment in fixed assets is the most volatile component of GDP, and indeed it is the collapse in investment that has driven the current recession. But investment decisions are driven by feelings and beliefs at least as much as rational calculation. More than 75 years ago Keynes identified the central role of what he termed `animal spirits’ in driving the business cycle – the confidence, or lack of confidence, that drives investment decisions. Investment decisions, dealing as they do with the future and the likely profitability, or not, of any given enterprise, are always by definition subject to uncertainty. In such circumstances rational calculation is almost impossible. Feelings and beliefs about the future, rather than utility maximisation, will drive decision-making.
Loss of confidence can be become a self-fulfilling prophecy. If, for whatever reason, business people become pessimistic and cease investing then demand in the economy will decrease and unemployment will rise. As unemployment rises, consumption starts to fall off and the economy’s prospects deteriorate further. This can in turn lead to an even greater loss of confidence – after all, who would choose to invest in the future in such circumstances? It is in times such as these that the government must step in and act as an investor of last resort, putting spare capacity to use, holding down unemployment and helping to restore confidence. The central role of animal spirits in the economics of Keynes led him to be deeply suspicious of attempts to model the macroeconomy. Under conditions of uncertainty, which is immeasurable, as opposed to risk, which is measurable, macroeconomics cannot be reduced to a series of simultaneous equations. Much of this insight was lost in the bastardised form of `Keynesianism’ that was practised by governments after the second world war and has been taught in universities ever since. Later students stopped reading the General Theory and many of its central lessons were forgotten. Animal spirits disappeared from modern macroeconomics, to be replaced by rational, utility-maximising agents – be they firms or households. In such a paradigm, there was little role for government, since there was no need for outside intervention to maintain confidence: investors would always act rationally.
Akerlof and Shiller have sought to address this. Their recent work seeks to replace utility maximising agents with real people and real firms making realistic decisions; it is a macroeconomics firmly rooted in the real world, a real economy in which the government must often intervene.
The full implications of their work are outside the scope of this article, but their discussion of the power of stories is central to a real understanding of the Greek situation.
As they write (p55):
Confidence is not just the emotional state of an individual. It is a view of other people’s confidence, and other people’s perceptions of other people’s confidence. It is also a view of the world – a popular model of current events, a public understanding of the mechanism of economic change as informed by the news media and by popular discussions.
Contrary to the central claim of neoclassical economics, human beings are more than rational calculating machines always trying to maximise their own utility; psychology matters and how people perceive events matters even more. Stories have power and ironically enough, one story with power is the notion of neo-classical economics.
Once a narrative has taken hold it can have concrete effect. This is nowhere more evident than in financial markets, where the nostrums of the `efficient market hypothesis’ have been widely accepted. Seeing a budget deficit of nearly 13 per cent of GDP, so-called bond market vigilantes will sell Greek bonds simply because they expect others to. And, as herd-like behaviour takes effect and Greek bond prices fall, the story becomes true. Each actor plays his or her part, as if acting from an unwritten, but well-known, script.
The myth which has gained traction in financial markets, and is widely propagated by the news media, and indeed Greece’s Eurozone partners, is that Greece massively overspent in the good years and is now approaching the point where it cannot meet its obligations. The only possible solution is said to be fiscal belt tightening on a huge scale.
Like all good myths this story contains an element of truth. However its central tenet – that in Greece there has been high government spending – is untrue. At around 40 per cent of GDP, Greek government spending is below European norms. The `profligate’ Greek government spends a lower portion of GDP than `austere’ Germany. The real reason for the fiscal gap is the chronic inability of the Greek state to collect the tax revenues due to it. Tax evasion is endemic throughout society. The rich avoid income taxes, and there is a thriving cash economy that neatly bypasses sales taxes. The extent of this imbalance between spending and receipts has been partially concealed for years by the Greek state’s lack of honesty in its official statistics.
But the imbalance, if not the extent of it, is not `new news’. For a decade or more financial markets were happy to continue lending to the Greek government despite its widely acknowledged budget deficit. Indeed, until very recently, several investment banks have been complicit in the government’s deception about the levels of the deficit, by using complex derivative contracts to help them minimise interest payments in the short term at the cost of higher payments later. This was the equivalent of subprime `teaser rate’ mortgages – but on a sovereign scale. As long as market participants were optimistic about the future they were happy to keep lending to the Greek state, despite the well-known issues of poor revenue collection, a not inconsiderable budget deficit and a short maturity government debt profile. The dominant narrative was one of confidence, underpinned by a belief that no Euro member-state could ever realistically default. But the collapse of Lehman changed this narrative: in a world where a titan of Wall Street could be allowed to fail, old certainties appeared less clear cut.
The story now is no longer one of a Euro member state with relatively bright and buoyant growth prospects, but one of a spendthrift government that has borrowed in order to lavish cash on needless public sector pay packets and pensions – and of a state that is out of control, is unable to rein in spending, and needs to `get a grip’ on its finances by cutting spending.
As long as this narrative holds, bond market actors will demand their pound of flesh. The story, reinforced by the media, is that only by cutting spending can Greece resolve its issues. Until they have watched this play out as they expect it to, bond market investors will be unwilling to lend to Greece at reasonable interest rates.
The Irish example
Ireland too has seen its story change. Just three years ago, Ireland was the `Celtic Tiger’. The Irish economic miracle had seen the country roar, as it embraced deregulation, slashed corporation tax and witnessed an influx of foreign direct investment, as multi-national after multi-national relocated to Dublin. But then the sharp falls in global liquidity from 2007 onwards killed the Irish commercial property market, and the collapse of that market dragged down with it the bloated banking sector. The government then stepped in, effectively nationalising their liabilities.
By early 2009, the story of the `economic miracle’ was discarded, to be replaced by a new tale – one of a government that had relied too much on the financial and property sectors and was burdened with debts it could no longer manage.As with Greece, bonds began to be sold off and the markets began to demand blood. The centre-right government, who seemed to buy the story as much as the markets, duly obliged. One year and three budgets later the results are plain to see. Deep cuts in public spending have included cutting unemployment and child benefits by 4 per cent, cutting the salaries of public sector workers by between 5 per cent and 10 per cent, a 7 per cent levy on public sector pensions, and a huge decrease in spending on education, health and transport. And thousands have been added to the dole queues. Unemployment stands at 13 per cent and national income has fallen by nearly 20 per cent.
The effect on the public finances has been dire. The budget deficit, which these cuts were supposed to close, has risen from 10 per cent of GDP to 11 per cent. The bonds have been downgraded. Potentially as damaging, the withdrawal of demand from the economy has seen a deep deflation set in (CPI inflation fell by 3.1 per cent in the year to March 2010). Falling prices cause the real value of government debt to rise. And despite this unfolding economic disaster, the Irish example is still praised. In the new narrative the question has become one of what else could they do.
Greece has, at most, two years before financing its debts becomes a live issue once more. In that time there are practical steps that can be taken. Effectively collecting tax revenues and ending the culture of non-payment would be a sensible starting point. This requires not only the enforcement of income tax levies on the wealthy and professionals, as well as the closing of some of the more obvious loopholes in the system, but also a new culture whereby the ordinary, working people of the country cease to partake in the black market to anywhere near its current extent. The government needs to make the case effectively that lost tax revenue will lead to spending cuts.
But in the final analysis, Greece cannot either tax its way or cut its way out of a 13 per cent deficit. Much of the gap must be closed by growth. Cutting public spending now, withdrawing demand from a stuttering economy, would be fatal.The narrative needs to change. Within Greece, increased government investment will help. As companies see their order books fill up with government work, they are likely to become more confident and hire more staff. As people feel more confident in their employment prospects they will spend more. This lowers the welfare rolls and increases the tax take. There is a strong role for the government to play in reviving `animal spirits’ and setting up a new national story of growth and optimism: private sector enterprise should respond to this.
Of course this will be hard for Greece to achieve alone. One government continuing to stimulate its economy in the face of nervous bond markets will put itself at risk of being targeted by vigilantes acting upon a story they believe to be true.
The Greek myth, that spending cuts are urgently needed and will restore economic prosperity, is now fast becoming a European myth. Austerity packages have been announced in Italy, Portugal, Spain and Germany.
In the final analysis the story needs to be changed at a European level. The Eurozone leaders who met in Brussels and agreed to `bail out’ Greece would have been better served by proposing a pan-European stimulus. An increase in domestic demand, whether led by the public or private sector, in Europe’s biggest economy, Germany, would be far more helpful to the stricken states of the European fringe than any number of `fiscal bailouts’. If money is to be transferred from Germany to Greece (and possibly Portugal, Spain and eventually maybe even Italy) then surely it would be better for all concerned if it was used to import goods for the German people, rather than simply to tide over the finances of the receiving governments. But instead of a co-ordinated stimulus, Europe – now joined by the UK – is embarking on a co-ordinated fiscal tightening. The results will be lower domestic demand and the real risk of deflation – Ireland writ large.
Government spending is not always the answer to economic problems, and budget deficits must eventually be dealt with – this is undeniable. But to begin tightening now, at a time when domestic demand is weak, monetary policy can not be eased any further, and the prospects for exports look grim, is folly on a continental scale.
Stories have power, whether they are true or not. The developing myth that Big Government is somehow to blame for the economic crisis, and that public debt has increased due to a spending splurge rather than a recession that originated in the financial sector, is now gaining traction in Britain. It is being vigorously pushed by the new Coalition government, and repeated, often without question, by the media. It needs to be combated, because if it is not then the story will run its course, and the ending is not an especially happy one.
Duncan Weldon is an economist. He began his career at the Bank of England before moving to fund management.